What's Getting a Hearing This Week: May 18-22

The sense of panic over the financial system seems to be abating, though there is considerable debate over (a) whether the economy will recover nicely or is just bottoming out for a prolonged period and (b) whether our banking system is sufficiently healthy to support a recovery. In any case, attention is shifting toward the question of financial-sector regulation. There is little doubt that failures of regulation contributed to the crisis, but what to do about it remains an open question.

Not surprisingly, several congressional committees are diving into the fray. Tomorrow, the House Financial Services Committee is holding a session on credit rating agencies -- those for-profit companies that gave AAA ratings to so many structured-credit products that collapsed last year -- and another Thursday on oversight of municipal finance.

The House Committee on Science and Technology has a hearing tomorrow on the solvency (or lack thereof) of the banking system, with a panel of economists including Jeffrey Sachs and Dean Baker, as well as our own Simon Johnson. And on Thursday, the Senate Homeland Security Committee is looking into "financial regulatory lessons from abroad."

There are many factors that will stand in the way of a comprehensive reform of financial regulation. In no particular order, these include:

Competition among federal regulatory agencies -- and, in cases like insurance, between federal and state agencies

A historical emphasis on regulation by type of institution (bank holding company vs. bank vs. thrift vs. insurer) rather than by the type of activity being regulated

International differences in regulation and the tendency of multinational companies to seek out the most permissive haven for operations

The American instinct to complain that regulation inhibits the freedom of companies to do as they wish

The strong and lasting influence that the financial institutions being regulated hold over Congress itself

Competition among congressional committees and among individual legislators

On a related topic, even the massive scandals of Enron and WorldCom gave us only the Sarbanes-Oxley Act, which after only a few short years had become the target of constant criticism claiming that it stifles innovation and forces companies to seek stock market listings abroad rather than in the United States.

Ultimately, I think, the long-term success of this wave of regulatory reform will depend not on the technical skill with which regulations are designed -- after all, as one reader said in an e-mail to me, who could have predicted 20 years ago the problems we are facing today? -- but on the ability of the new regulation to avoid capture and distortion by the financial sector itself. After all, we already had capital adequacy requirements, but the financial sector succeeded in effectively exempting derivatives from those requirements, and then lobbied to increase the leverage allowed to investment banks.

Laws often establish certain principles and then authorize agencies such as the Securities and Exchange Commission to write rules implementing those principles; in that situation, the key thing is who can influence the SEC. That's the question that I think congressmen should be asking.

Besides the regulatory events, we'll also be covering a Joint Economic Committee hearing on the impact (past and future) of oil prices on the economy, with a guest post by James Hamilton of Econbrowser.com. And, on Wednesday, Treasury Secretary Tim Geithner is scheduled to go before yet another panel, this time the Senate Banking Committee, to hear yet more criticism of the Troubled Assets Relief Program. Sometimes I feel sorry for that man.

Whatever the number one question to any credit rating agency in any hearing on this financial crisis should be the following:

Do you feel you really deserve that the bank regulators should trust you so much that they allow a bank to leverage itself 62.5 to times to 1 on loans that carry your AAA stamp of approval, and in some extreme cases even up to 179 to 1?

They will most probably not make that question because most experts who should have been able to forewarn the crisis but never did, have not the slightest idea of what the minimum capital requirements for banks that were designed by the Basel Committee really meant.